Battle of Home Improvement Retailers: Lowe's vs. Home Depot

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 |  Includes: HD, LOW
by: The Ethical Investor

According to the Home Improvement Research Institute, home improvement product sales are expected to grow at an annual rate of approximately 5% from $265 billion to $344 billion by 2015. This field is dominated by two companies - Lowe’s Companies, Inc. (NYSE:LOW) and The Home Depot, Inc. (NYSE:HD). Although the housing market remains weak, several drivers such as aging of homes and remodeling should provide adequate support to these retailers. Both companies have wide economic moats and can be expected to stay in business for decades to come.

In this article, I will fundamentally analyze these home improvement stores and provide my future price targets.

Cash Conversion Cycle

As I mentioned in an article on teen retailers, I consider the Cash Conversion Cycle (CCC) to be a great metric to compare the performance of similar retailers. The historical CCC for the two companies and the results are shown in the table that follows. It should be noted that Days Receivables Outstanding was not considered as part of the CCC calculation.

CCC (Days)

FY

LOW

HD

2006

44

32

2007

43

40

2008

45

45

2009

48

47

2010

45

46

Average

45

42

Click to enlarge

As shown in the table, LOW has had a very consistent CCC ranging from a low of 43 to a high of 48. As of last year, both the companies had a very similar CCC of 45 to 4 days. I don’t see any one company having a significant advantage over the other using this metric.

Return on Invested Capital

Next, I investigated the historical return on invested capital. During the housing boom, the two companies were generating return in excess of 15%. The recession significantly reduced the profitability of the two companies with the ROIC of LOW and HD falling to 7% and 9% respectively by 2009. In recent quarters, the companies have shown signs of improvement with HD leading the way.

ROIC

FY

LOW

HD

2006

16%

17%

2007

13%

13%

2008

9%

7%

2009

7%

9%

2010

8%

12%

Average

11%

12%

Click to enlarge

Growth Rates

Looking at historical growth rates, LOW has outperformed in this category by growing its revenues at an annual rate of 2% during the last 5 years compared with the decline in revenue at HD. Going forward, the companies are expected to grow their earnings at an annual rate of 13% to 14%.

Revenue Growth Rates

LOW

HD

Year on Year

3%

3%

3-Year Average

0%

-4%

5-Year Average

2%

-4%

Click to enlarge

Operating Margins

I also compared the operating margins of the two firms to analyze the effectiveness of the management. The companies have reported similar margins over the last 5 years with HD outperforming LOW during the last financial year. However, historically LOW has had a slightly higher operating margin than HD.

Operating Margin

FY

LOW

HD

2006

11%

11%

2007

10%

9%

2008

8%

6%

2009

7%

7%

2010

7%

9%

Average

9%

8%

Click to enlarge

Valuation

In financial year 2012, I expect LOW and HD to grow their revenues by 4% and 2.5% respectively. Adjusting for the decline in share count due to buybacks, my revenue and EPS estimates for the two companies for the financial year ending January 2012, are shown in the table below.

LOW

HD

Revenue (millions)

My Estimate

$50,768

$69,676

Average Analyst

$50,580

$69,640

EPS

My Estimate

$1.59

$2.20

Average Analyst

$1.64

$2.31

Click to enlarge

Next, based on historical analysis, I developed estimates for future P/E and P/S multiples using data for the last 10 years. The estimates and the resulting future fair values are shown below.

LOW

HD

P/E

Estimate

15.66

16.5

Fair Value

$25

$36

P/S

Estimate

0.7

0.72

Fair Value

$27

$32

Average Price Target

$26

$34

Current Price

$24.25

$36

% Return

7%

-6%

Click to enlarge

* - As of May 27, 2011

Based on my analysis, LOW is currently undervalued by approximately 7% while HD is overvalued by 6%. Since these companies are fairly stable with medium to low risk levels, applying a discount rate of 12% (my minimum acceptable return), I derive an entry point of $23 for LOW and $30 for HD. Trading at approximately $24, LOW is more likely to fall to my target level and when that happens, I would look to open a long term position.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: Use this article for information purposes only. Please consult your investment advisor before making any investment decision.